Manufacturing / White Paper

Active Carbon Management Part 2

The Outlook for Profit Impacts Related to Greenhouse Gas Emissions

Archstone Consulting published the first in a series of articles addressing the challenges that industry faces in dealing with the rapid increase in energy costs, introducing our overall approach to the understanding, evaluation, management and prioritization of energy/fuel cost reduction and management, called Active Carbon Management. For further details on that topic, please see "Active Carbon Management - A More Systematic Approach to Energy Consumption and Cost Management".

In this article, we will examine further the trends and challenges of energy costs and their longer term prospects and begin a discussion of the increased attention and risk facing industry in the United States over the impact of Greenhouse Gas (GHG) emissions. We will discuss what companies should do to prepare for potential new regulatory structures (e.g. carbon tax, cap and trade, etc.) and describe the potential profitability impact we see for companies willing to act aggressively. We believe that energy costs and greenhouse gas emissions costs are one of the major untapped cost pools that industry can pursue for reduction and profitability enhancement. These costs can be described as "unrecognized," due in part to the diffuse nature of energy expenditures, and also due to the pending nature of most GHG costs.

From an energy cost perspective, we are now in a new world. The recent run up in energy costs over the past 20 months and associated volatility marks the first time we have encountered a true demand driven energy crisis. Historically, price spikes have been caused by supply disruptions, but this time we are facing the law of large numbers, as applied to the elevation of a significant portion of poor citizens to middle class in countries such as India and China. In his new book, Hot, Flat, and Crowded, the New York Times columnist and Pulitzer Prize winning author Thomas Friedman describes how the elevation of 94 million poor people to middle class status (greater than the population of Germany) within a single year has triggered a significant increase in energy demand. The days are gone when the "developed world could scan the horizon and see nothing but available, low cost energy". Looking at it another way, whenT. Boone Pickens is promoting wind energy, times have truly changed.

As the world dynamics of population growth and economic development continue to change, we see that they inevitably drive toward a single concern: economic growth requires energy, and energy consumption, in its current form equals greenhouse gas emissions. The elevation of huge populations (China, India) from third-world to aspiring first-world status puts tremendous pressure on everyone with respect to greenhouse gas emissions, and hence the two pronged effect on established business enterprises higher energy costs, and increasing political/regulatory pressure on GHG emissions.

Most companies are not prepared for the ripple effects from this trend. It will impact industries and companies in unexpected ways. Shifts in product design, raw material usage, facility location, supply chain network design, and many other areas of corporate decision-making will move in new and challenging directions as the impact of high energy prices and GHG emissions trickle throughout the entire value chain. It is important to note, as we did in our prior article, Active Carbon Management, that over the long run, resource costs will inevitably drop as recycling, substitution, technological development, and other factors take effect. However, this is the economist's view of the problem of scarcity and price. For the purposes of companies that are facing quarterly reporting requirements, day-to-day disruptions and cost pressures, we instead use the engineering point-of-view on scarcity and costs, with its shorter-term focus.

This ripple effect is already affecting several major contract manufacturing service providers, which have dominated electronics production for the past several years. These service providers are now under increasing pressure to find new sources of revenue growth, more regionalized production facility structures, and cost reduction targets driven in part by rising energy costs. Highly energy intensive industries, like petrochemicals, are struggling with the double impact of both feedstock and energy input costs jumping to unprecedented levels. Certain regions of the world with advantaged natural gas costs (Russia, the Middle East, and Venezuela) will see an increase in their share of petrochemical product manufacture, while other locations, such as the US, have already seen declines.

On the consumer side, the combined effect of consistent press reporting, political advocacy group actions, election year conversations and maturing points of view are having an effect. Consumer buying patterns are changing as customers become more educated and selective and make choices based on "green" perception. Some companies have already adopted strategies to attract the newly educated consumer. For example, in mid-2007 The Home Depot launched its Eco Options program, which brands products that are either eco-friendly or have satisfied environmental performance criteria as set forth by Scientific Certification Systems, an independent standards development company. By its own estimate, sales of Eco Options products have prevented 7.7 billion pounds of CO2 from being released into the atmosphere. Chairman and CEO Frank Blake illuminated part of Home Depot's motivation in launching this program when he stated, "Eco Options is the next step in... making sure we help our customers who want to make a difference themselves."

In addition, Home Depot has publicized a variety of small steps designed to to highlight efforts to reduce global warming. For example, the company is planting trees to offset company-generated emissions. While these activities benefit Home Depot's reputation in the eyes of the consumer as an environmentally responsible company, the net economic and environmental benefit remain questionable.

Actions that will have a greater impact include HVAC and lighting changes. The retailer reported, "by replacing HVAC units in approximately 200 existing stores and switching to the use of T-5 lighting in approximately 600 existing stores, we estimate savings to be approximately $20 million since fiscal 2006...We estimate that by implementing these energy saving programs we have avoided 907 million pounds of greenhouse gas emissions...equivalent to removing 75,000 cars from the highway." The company accomplished these savings in one year's time with a $50 million budget for energy efficiency related projects. While that was a one-time investment the savings will continue to accumulate annually.

Consumer Demand

Tom Delay, CEO of the Carbon Trust says of a recent survey his organization conducted, "Our research tells us that consumer demand for low carbon products is stirring. In a world where the consumer is king and carbon is the new currency, companies that move first to develop low carbon products have much to gain." He continues, "Cutting carbon in the supply chain is the next critical stage in the business contribution to reduce carbon emissions to tackle climate change and...represents a significant commercial opportunity. Delivering low carbon products into the hands of consumers will not only reduce energy bills and enhance corporate and brand reputation; but will open up new revenue streams and increases brand loyalty if properly communicated."

A review of typical responses by businesses to either of the "two prongs" we described earlier (energy costs and GHG regulatory concerns) shows that the vast majority of these are superficial, reactive, and, for the most part, scattershot. A more systematic approach, that recognizes the global, growth driven reality we face is in order. This creates an opportunity for many companies to capture improved profitability and identify new market
opportunities.

Risks of Inaction

From an investment perspective, the size of a company's GHG "footprint" is now viewed as a potential investment risk. The Carbon Disclosure Project (CDP), sponsored by more than 350 international financial institutions and banks, has been tracking self reported CO2 emissions by major global and regional companies for the last six years. In its latest report, CDP is actively reporting companies by segment that are reporting their CO2 emissions footprint, as well as highlighting those that "do not respond". Additionally, companies are given a CDLI rating (Climate Disclosure Leadership Index) and further rated on their overall CO2 emissions performance, in a format strikingly similar to a bond rating. It shows we are a few short steps away from having CO2 emissions performance begin to impact access to capital.

The gap between levels of corporate carbon awareness and corporate action is shrinking. In a 2007 survey conducted by the CDP, an analysis of companies in the FT500 revealed that 95% of surveyed companies feel that climate change presents a commercial risk to their business. And, in response to this belief, 76% of these companies say they have implemented some type of greenhouse gas reduction initiative. The percentage of companies implementing initiatives is up from 48% the previous year. The definition, however, of a "GHG initiative" is quite broad, and suggests that these efforts are still not a true priority.

Political/Regulatory Pressure

Based upon the stated policy positions of President Obama, U.S. government regulation of carbon emissions will be a priority for the new administration. In fact, at the state level, government has already taken steps to hold companies liable for GHG reduction. The Western Climate Initiative (WCI) is an agreement among states and provinces of the western rim of North America (including California, Arizona, and Ontario) to reduce 2005 GHG levels by 15% in 2020. Companies with annual emissions greater than 10,000 metric tons of CO2 are subject to a"cap" on the maximum amount of carbon emissions allowed. Participants then have the option to reduce carbon output through the trade or purchase of "carbon credits" on the open market to be in compliance. Another example is the Regional Greenhouse Initiative, a market-based effort to reduce GHG emissions on the East Coast. Participating states include Connecticut, New York, and Vermont. In fact, this system has been active in Europe where the price of a ton of carbon emission is approximately $20. In the US, we expect that prices could be as high as $50 per ton and penalties for non-compliance could begin at approximately $60 per ton and climb as high as $500 in the coming decades.

As with most new areas of public interest, legislation at all levels of government - local, state, and national - is affecting US companies in a patchwork fashion. There are also emerging trends which reveal that organizations and companies taking initiative to voluntarily reduce and report carbon emissions are rewarded. In California, cities and developers that comply with carbon friendly urban planning are rewarded with increased funding and fewer regulatory hurdles. In addition, those who elect to report their carbon emission levels to the Climate Registry in Southern California are likely to have more influence in future government regulations regarding carbon management. Further measures across the country are, no doubt, on the horizon. Some have said. "as California goes, so goes the nation". As a result, we can expect a reaction from industry to "consolidate" state-by-state regulations into a national framework under the EPA.

At the highest level, the goal for companies is to increase the output of economic value at a greater rate than the output of greenhouse gases. Or, more precisely, the economic value, over time, should increase relative to the economic value created; efficiency needs to improve over time. With industries that emit high levels of GHG (e.g. Utilities, Oil & Gas, Metal, Mining, & Steel) and are under increasing regulatory pressure and public scrutiny, increased efficiency will result in immediate and lasting bottom-line savings.

A leader in this field has been Pacific Gas and Electric Corporation (PG&E). Known for a low emissions profile, in part due to its heritage of clean (low or no GHG) energy sources such as hydroelectric and nuclear, PG&E reported an average CO2 emissions rate of 44 lbs CO2/MWh in 2005 for company owned generation and 489 lbs CO2/MWh for their overall delivery mix. Compared to the average CO2 emissions for California at approximately 879 lbs CO2/MWh and the national average at 1,369 lbs CO2/MWh, PG&E clearly has an operating advantage. PG&E's success is not solely based on their blend of renewable and cleaner energy sources, but also their commitment to proactively evaluate and measure their emissions. Additionally, they have adopted new strategies that not only reduce emissions but also deliver operational, cost-saving efficiencies. Over the last several decades, "PG&E's customer energy efficiency efforts, both electric and natural gas, have achieved significant cumulative lifecycle energy and costs savings, on the order of $9 billion, and prevented approximately 125 million tons of CO2 from entering the atmosphere." These tactical measures demonstrate that carbon management strategies result in bottom line savings.

If you determine that your company produces significant amounts of GHG and that it will likely be a target for regulation, the time to act is now. By putting a plan in place, you can remain ahead of the GHG efficiency curve and proactively address emerging issues, regulations and competitive challenges.

A Plan for Action

Companies that are under cost and/or regulatory pressure should develop a comprehensive approach to Active Carbon Management, that evaluates and benchmarks current and historical energy use and GHG impact, addresses key value chain issues, and aligns with the goals of shareholders and senior management. Our recommendation is to establish a true, comprehensive baseline on costs and GHG emissions, both to measure performance improvements initiatives and to respond to external agencies, lending institutions, and public interest groups.

In the larger context all companies should engage three basic concepts into their carbon cost reduction framework:

Attack Immediate Energy Cost Reduction Opportunities through Active Carbon Management Process - Secure sponsorship for Active Carbon Management from senior level management drive the process through the entire value chain. Create an inventory of energy costs including not just procurement and manufacturing costs, but the input costs to research and development, disposal management costs and costs associated with suppliers and distributors. With a current cost benchmark in place you can build your future cost picture and tie gaps and opportunities directly to achievable results.

Prepare for GHG Driven Regulations and Markets - Define metrics that anticipate future industry regulations and markets, that consider competitive forces from industry peers and that incorporate future company growth and carbon reduction capabilities. Define a baseline and build in future flexibility to protect against volatility in regulations and instability in the markets. Build a reporting model that tracks progress against the baseline and provides visibility to quick win accomplishments to help spotlight successes and gain further executive support. With metrics, a baseline and a reporting model in place establish a governance model to establish roles and responsibilities and a reporting structure that communicates results to management and shareholders.

Monitor and Improve Based on Shareholder Return - As cost reduction opportunities are identified and executed throughout the value chain continue to identify new opportunities and improve upon current successes. Continue to monitor the regulatory environment and adjust current plans according to new regulations and market information. A one-time effort or static response is not enough to avert risk or achieve a competitive advantage.

What is the timing of these risks?

The reality of both energy cost economics and coming regulatory pressures suggests that the sooner these issues are addressed head-on, the better. There are many potential opportunities to reduce energy consumption, directly resulting in GHG reductions, and improve cost performance. The key is identification and prioritization by senior management. Companies, especially those that are major energy consumers or producers need to take a systematic and planned approach to economically address the issue. Reactive businesses will pay a hefty price while proactive businesses will not only ensure cost avoidance, but likely see revenue enhancements through innovation and improved energy delivery infrastructure.

Conclusion

The combined effect of high energy costs, rapidly growing global demand for energy, and public acceptance of GHG regulations and control will have far reaching effects on businesses. The proper response for business organizations is to establish a comprehensive baseline understanding of current energy consumption and GHG emissions, and develop plans to measure, reduce, and report, thus taking control of a process that is likely to be very expensive if these tasks are left to regulatory agencies or if organizations wait until shareholder pressure drives action.